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Monday, 20 May 2013

Controversial investment advice: Only invest in what you understand

This post will cover my firm idea that people should only invest in products and investments which they understand themselves and should not 'trust' others to do hat is in their own best interest. It is controversial because it suggests that you and I as investors and savers should not be giving over responsibility for our financial well being to others (i.e. those in the investment community).

Why you should ONLY invest in what you understand
You should only invest in what you understand for a few fundamental reasons including:

When you invest in financial products there is a risk / reward trade off

When you understand what you are investing in, you understand both the upside and the downside

All too often people only focus on the upside, or are only interested in hearing the upside. If you do not understand the downside or the potential pitfalls of an investments you may take on more risk than you are comfortable with

You will never be taken advantage of

We all know that there are unscrupulous operators out there and there is ample evidence in the media of 'scams' and dodgy investments which are constantly being uncovered

I can guarantee you that the people who get taken in by the scams are those who do not understand what they are investing in, or the true nature of the investment

It is one thing to lose money because the market moved against you, it is quite another to be taken in by a fraudster because you were promised returns without understand exactly how you were getting them

You are responsible for your OWN financial well being

The finance world is one in which survival of the fittest is the rule of thumb

We can argue about whether this is right or wrong and whether it should be this way but unfortunately finance is a zero sum game - for someone to win someone else needs to lose

Although governments and regulators can try and protect against unscrupulous operators they cannot change the win / lose nature of the market

To be on the winning side therefore you need to be acting in your own best interests

I do not think you can act in your own best interests if you do not understand what you are investing in

Note that my focus on understanding what you invest in does not mean that you cannot use advisers, financial planners, brokers or managed products. However it does mean that you need to understand exactly what these advisers are recommending and what the managed products entail, contain and the risks associated with them.

Why not having expertise, interest or skill is NOT an excuse
I ran this idea past several of my friends. There was an interesting divide in responses. Those people who worked in the finance industry or who were very interested in their own finances totally agreed with it. Those who found investing a chore typically thought I was being unreasonable.

The most common push back against my argument was 'not everyone is interested in finance - does that mean they should not invest in the stock market at all?'. The analogy was often given that people who do not understand how to care for themselves went to a doctor for advice and followed a trusted medical professionals advice even though they do not understand what is being done or prescribed for them.

I think the doctor analogy (which got touted to me remarkably often) is slightly misleading. I think that when you go to the doctor that you should be asking questions around risks around procedures and medications. I think that you should to the greatest extent possible understand what you are being treated for and with what. The difference is, however, that sometimes at the doctor you fundamentally do not have a choice. You can either trust the doctor to do what is right or have serious adverse medical consequences. There is no equivalent in finance. The worst that can happen to you if you choose not to follow your financial planners investment advice is that you keep your money in cash and lose it through inflation each year. The fact that you do not have to act in finance is the difference between this and the medical analogy.

I also think that not having an interest or skill in finance is not an excuse because everyone has the option to invest in products that they do understand. You will probably get a lower return if you are not interested in finance or in educating yourself about financial matters but you are also less likely to lose money. And before you tell me that you not NOTHING about finance....

Even people who are completely disinterested know how SOME financial products work
The idea that some people have no idea how any financial products work is plain wrong. The problem is more they do not apply this fundamental knowledge appropriately. That is they do not stop and think about the risks and rewards of what they are doing even if they fundamentally know them.

At the most basic example - everyone knows how interest from a bank account works. This knowledge would extend to term deposits, high interest saving accounts and other types of bank accounts including specials and short term deals. The part people miss is the risk of default of a bank - for example a smaller bank is more likely to go bust than a bigger bank so you need to think about this when trying to get a little bit more interest.

People also fundamentally understand how real estate investment works. They know that the landlord gets rent and if they have rented before or lived in their own house they have a pretty good idea of what the expenses will be. They need that extra bit of research to work out exactly what they need to do and what sort of return they need to get but people fundamentally understand this.

The share market is much more complex. However it doesn't really take long to explain index funds although if a person wants to invest in specific biotechnology stocks they better have a whole lot of understanding other than a 'buy' rating by their broker. If you do not have time to research a specific company do not invest in them.

The moral of the story: invest ONLY in what you understand

People have a whole range of financial products to invest in which they do understand. I find it crazy therefore that people constantly want higher returns and so venture into areas they do not understand.

Do you really want to be the person on the news lamenting the fact that they lost a whole heap of money in a financial product that was recommended to them but they didn't really understand? If you do not understand exactly how an investment generates returns for you then you shouldn't be in it. It is no use blaming someone after you have no money left.

This is why I think financial education and constantly educating yourself is so important. If you can't be bothered then stick to the simple investments. There is nothing wrong with them - you will not get as high a return but you will be much less likely to blow yourself up too!